[4830-01-u]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8761]

RIN 1545-AV80

Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations providing

guidance regarding satisfaction of the continuity of interest

requirement for corporate reorganizations. The temporary

regulations affect corporations and their shareholders. Final

regulations published elsewhere in this issue of the Federal

Register also provide guidance regarding satisfaction of the

continuity of interest requirement for corporate reorganizations.

These temporary regulations amplify the final regulations. The

text of these temporary regulations also serves as the text of

proposed regulations published elsewhere in this issue of the

Federal Register.

DATES: These regulations are effective January 28, 1998.

Applicability: These regulations apply to transactions

occurring after January 28, 1998, except that they do not apply

to any transaction occurring pursuant to a written agreement

which is (subject to customary conditions) binding on January 28,

1998, and at all times thereafter.

FOR FURTHER INFORMATION CONTACT: Phoebe Bennett, (202) 622-7750

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

This document contains amendments to the Income Tax

Regulations (26 CFR part 1) under section 368. These temporary

regulations provide that, in determining whether the continuity

of interest requirement for corporate reorganizations is

satisfied with respect to a potential reorganization, a

proprietary interest in the target corporation is not preserved

if, in connection with a potential reorganization, it is redeemed

or acquired by a person related to the target corporation, or to

the extent that, prior to and in connection with a potential

reorganization, an extraordinary distribution is made with

respect to it.

Background
On December 23, 1996, the IRS published a notice of proposed

rulemaking (REG-252231-96) in the Federal Register (61 FR 67512)

relating to the continuity of interest requirement. Many written

comments were received in response to this notice of proposed

rulemaking. A public hearing on the proposed regulations was

held on May 7, 1997. After consideration of all comments, the

regulations proposed by REG-252231-96 are adopted as final

regulations, and published elsewhere in this issue of the Federal

Register. These temporary regulations supplement the final

regulations.

Explanation of Provisions
Final regulations published elsewhere in this issue of the

Federal Register provide that in determining whether the

continuity of interest (COI) requirement for corporate

reorganizations is satisfied, dispositions of stock of the target

corporation (T) by a T shareholder generally are not taken into

account.

Redemptions of T Stock or Extraordinary Distributions with

Respect to T Stock

Commentators requested guidance on the circumstances under

which a redemption by T of its stock would adversely affect

satisfaction of the COI requirement.

Some commentators suggested that the IRS and Treasury

Department adopt an approach that would identify either the

issuing corporation (P) or T as the source of the funds for the

redemption. If, in connection with an acquisition of T, the

facts and circumstances indicate that P did not directly or

indirectly furnish funds used by T to redeem T shareholders,

these commentators suggested that satisfaction of the COI

requirement should not be adversely affected. In many

transactions, however, such a tracing approach would be extremely

difficult to administer. For example, if P acquired the assets,

rather than the stock, of T or if T redeemed stock for a note, it

would be unclear in many circumstances whether in substance T or

P assets were used to fund the redemption or to repay the note.

Another commentator suggested that redemptions by T in

connection with a potential reorganization should adversely

affect satisfaction of the COI requirement because the effect on

COI is the same as if P had furnished the redemption

consideration in the transaction. The temporary regulations

generally adopt this approach because it reflects that T and P

will be combined economically and because of the difficulties of

administering a tracing approach, as previously described.

Treatment of stock redeemed by T as proprietary interests

that are not preserved in the reorganization also accords the

same tax result to transactions that reach the same result by

different steps. For example, T could merge into P for a

combination of consideration, of which 30 percent is P stock and

70 percent is a P promissory note. Conversely, T could issue its

promissory note to redeem 70 percent of the T stock and then P

would assume the T note in the merger, in which the remaining T

shareholders receive solely P stock. From the perspective of P,

T, and the T shareholders, these two transactions are

substantively identical, and the COI requirement is not satisfied

in the first transaction. The temporary regulations provide that

the second transaction likewise does not satisfy the COI

requirement.

In addition, this approach corresponds with the rule of the

final regulations that a proprietary interest in T is not

preserved if, in connection with the potential reorganization, P

stock furnished in exchange for a proprietary interest in T in

the potential reorganization is redeemed. Because the final

regulations do not inquire, in the case of a subsequent P

redemption, whether the source of consideration furnished in the

redemption was former T assets or historic P assets, the

temporary regulations similarly do not make an inquiry in the

case of a prior T redemption. Instead, for purposes of the COI

requirement, the temporary regulations treat T and P as a

combined economic enterprise. In an asset acquisition, this

approach avoids the difficult process of identifying the source

of payments as between T and P.

Commentators have suggested that this approach is

inconsistent with authorities which hold that redemptions of

stock of the target corporation with assets of the target

corporation do not violate the solely-for-voting-stock

requirement applicable to section 368(a)(1)(B) reorganizations.

See, e.g., Rev. Rul. 55-440 (1955-2 C.B. 226). None of these

authorities address the effect on continuity of interest of such

redemptions. For the reasons stated above, the temporary

regulations take such redemptions into account for continuity

purposes.

The temporary regulations provide that a proprietary

interest in T is not preserved if, in connection with a potential

reorganization, it is redeemed or to the extent that, prior to

and in connection with a potential reorganization, an

extraordinary distribution is made with respect to it. An

extraordinary distribution with respect to T stock, followed by a

sale of the remaining T stock to P, has the same effect on the

value of the proprietary interest in T as a pro rata redemption

by T followed by a sale of the outstanding T stock to P.

The temporary regulations do not provide guidance on the

determination of whether a distribution will be treated as an

extraordinary distribution, except that the rules of section 1059

do not apply for this purpose. The IRS and Treasury Department
invite comments on whether the regulations should provide more

specific guidance in this area.

A section 355 distribution of controlled corporation stock

by T will preserve a proprietary interest in T, except to the

extent that the T shareholders receive other property or money to

which section 356(a) applies or the distribution is extraordinary

in amount and is a distribution of property or money to which

section 356(b) applies.

Related Person Rule

In determining whether the COI requirement is satisfied,

dispositions of T stock to persons that are not related to T or P

are disregarded. The final regulations provide that a

proprietary interest in T is not preserved if, in connection with

a potential reorganization, a person related to P acquires, with

consideration other than a proprietary interest in P, T stock or

P stock furnished in exchange for a proprietary interest in T in

the potential reorganization. Consistent with the final

regulations, the temporary regulations provide that a proprietary

interest in T is not preserved if, prior to and in connection

with a potential reorganization, a person related to T acquires T

stock with consideration other than T stock or P stock.

Definition of Related Person of T

The final regulations include as related persons any

corporation that is a member of the affiliated group, within the

meaning of section 1504, of which P is a member, and any

corporation whose purchase of P stock would be treated as a

redemption of that stock under section 304(a)(2). The section

1504 test was adopted because the IRS and Treasury Department

were concerned that acquisitions of T stock or P stock by P

affiliated corporations were no different in substance than

acquisitions or redemptions by P. This concern does not

generally extend to members of T’s affiliated group that are not

also considered related to T under section 304(a)(2) because such

corporations are T shareholders participating in the potential

reorganization along with the other shareholders of the target

corporation. The temporary regulations treat two corporations as

related persons if a purchase of the stock of one corporation by

another corporation would be treated as a distribution in

redemption of the stock of the first corporation under section

304(a)(2) (determined without regard to §1.1502-80(b)).

Effect on Other Authorities

These COI regulations apply solely for purposes of

determining whether the COI requirement is satisfied. No

inference should be drawn from any provision of this regulation

as to whether other reorganization requirements are satisfied, or

as to the characterization of a related transaction. See, e.g.,

§1.301-1(l).

Effect on Other Documents

Rev. Proc. 77-37 (1977-2 C.B. 568) and Rev. Proc. 86-42

(1986-2 C.B. 722) will be modified to the extent inconsistent

with these temporary regulations.

Effective Date
These regulations apply to transactions occurring after

January 28, 1998, except that they do not apply to any

transaction occurring pursuant to a written agreement which is

(subject to customary conditions) binding on January 28, 1998,

and at all times thereafter.

Special Analyses
It has been determined that these temporary regulations are

not a significant regulatory action as defined in EO 12866.

Therefore, a regulatory assessment is not required. It also has

been determined that section 553(b) of the Administrative

Procedure Act (5 U.S.C. chapter 5) does not apply to these

temporary regulations and, because the temporary regulations do

not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Therefore, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Internal Revenue Code, these

regulations will be submitted to the Chief Counsel for Advocacy

of the Small Business Administration for comment on its impact on

small business.

Drafting Information
The principal author of these regulations is Phoebe Bennett

of the Office of the Assistant Chief Counsel (Corporate), IRS.

However, other personnel from the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

 Paragraph 1. The authority citation for part 1 continues to

read in part as follows:

Authority: 26 U.S.C. 7805. * * *

Par. 2. Section 1.368-1T is added to read as follows:

§1.368-1T Purpose and scope of exception of reorganization

exchanges (temporary).

(a) through (e)(1)(i) [Reserved] For further guidance see

§1.368-1(a) through (e)(1)(i).

(e)(1)(ii)(A) General rule. A proprietary interest in the

target corporation (other than one held by the acquiring

corporation) is not preserved if, prior to and in connection with

a potential reorganization, it is redeemed or to the extent that,

prior to and in connection with a potential reorganization, an

extraordinary distribution is made with respect to it. The

determination of whether a distribution with respect to stock of

the target corporation is an extraordinary distribution for

purposes of this paragraph (e)(1)(ii) will be made on the basis

of all of the facts and circumstances, but the treatment of the

distribution under section 1059 (relating to extraordinary

dividends) will not be taken into account.

(B) Exception. Paragraph (e)(1)(ii)(A) of this section

does not apply to a distribution of stock by the target

corporation to which section 355(a) (or so much of section 356 as

relates to section 355) applies, except to the extent that--

(1) The target corporation shareholders receive other

property or money to which section 356(a) applies; or

(2) The distribution is extraordinary in amount and is a

distribution of property or money to which section 356(b)

applies.

(2)(i) [Reserved] For further guidance, see

§1.368-1(e)(2)(i).

(ii) A proprietary interest in the target corporation is not

preserved if, prior to and in connection with a potential

reorganization, a person related (as defined in §1.368-1(e)(3)

determined without regard to §1.368-1(e)(3)(i)(A)) to the target

corporation acquires stock of the target corporation, with

consideration other than stock of either the target corporation

or the issuing corporation.

(e)(3) through (e)(6) Example 9. [Reserved] For further

guidance, see §1.368-1(e)(3) through (e)(6) Example 9.

(e)(6) Example 10. Acquisition of target corporation stock

before merger. (i) Redemption by target corporation. A owns 85
percent and B owns 15 percent of the stock of T. The fair market
value of T is $100x. Neither A nor B own stock of P. Prior to
and in connection with the merger of T into P, T redeems A's T
stock for $85x and issues to A its promissory note in exchange
for the stock. At the time of the merger T has a value of $15x,
after giving effect to the redemption of its stock. In the
merger, B receives solely P stock. The continuity of interest
requirement is not satisfied because T redeemed A's stock, and a
substantial part of the value of the proprietary interest in T is
not preserved. See paragraph (e)(1)(ii)(A) of this section.

(ii) Purchase by person related to target corporation. The

facts are the same as paragraph (i) of this Example 10, except
that X, T's wholly owned subsidiary, acquires A's T stock prior
to and in connection with the merger for cash of $85x. Under
paragraph (e)(2)(ii) of this section and §1.368-1(e)(3)(i)(B),
X's acquisition of A's T stock is an acquisition by a related
person. The continuity of interest requirement is not satisfied,
because X acquired T stock, for consideration other than P stock,
and a substantial part of the value of the proprietary interest
in T is not preserved. See paragraph (e)(2)(ii) of this section.

Example 11. Extraordinary distribution before merger. A

owns all of the stock of T. The fair market value of T is $100x.
Prior to and in connection with the merger of T into P, T pays A
an extraordinary distribution of an $85x note. T merges into P,
and A receives solely P stock. P assumes T’s obligation on the
note. The continuity of interest requirement is not satisfied,
because T paid A an extraordinary distribution, and a substantial
part of the value of the proprietary interest in T is not
preserved. See paragraph (e)(1)(ii)(A) of this section.
 (f) Effective date. This section applies to transactions

occurring after January 28, 1998, except that it does not apply

to any transaction occurring pursuant to a written agreement

which is (subject to customary conditions) binding on January 28,

1998, and at all times thereafter.

Michael P. Dolan

Deputy Commissioner of Internal Revenue

Approved: January 12, 1998

Donald C. Lubick

Acting Assistant Secretary of the Treasury